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Long-term rates: a regime shift, a fluctuation band shift?

 

The essential

The rise in bond yields since Trump’s election is not surprising, but it raises a crucial question: are we witnessing a radical reversal of the underlying trend that has been driving for decades (i.e. bonds yields decline), have we ended with abnormally low rates, or is it “simply” one of those many corrections that we regularly attend? Clearly, is it a regime shift, a change of level, or a correction within a fluctuation band? After analysing the usual and specific triggers for bond yields increases, five conclusions have to be pointed out:

  1. In the absence of a new growth cycle, US bond yields should remain within a 1.5% to 3% fluctuation band;
  2. There should be no regime shift for the core euro bond yields, as well as for Japanese rates. The level of growth and inflation, as well as the monetary policies carried out, do not justify it.
  3. Contagion from US rates will be limited as long as expectations of regime shift will remain low in the United States.
  4. Only the interruption of QEs seems likely to significantly and permanently change the level of euro area bond yields.
  5.  Finally, the European elections and the uncertainty they represent seem, on the other hand, to be sufficiently crucial to bring about a change in the level of peripheral countries bonds’ spreads.

 

CROSS ASSET (Download)

Flag-UK
February 2017

 

Flag-FR
Février 2017

 

The Article

L'Article

 

We have repeatedly analysed the reasons explaining why D. Trump’s election has resulted in a rise in bond yields: the priority for US growth, the prospects for the reversal of fiscal and tax policies at a time when inflation is going back above the Fed’s target, giving the Fed an unquestionable room for manoeuvre, allowing it to proceed with interest rate hikes.

All this naturally led to widening spreads between the United States and Europe over the entire curve. European bond yields (both sovereigns and corporates) entered into negative territory in 2016, but the rise in US bond yields has largely changed the situation: if in September more than 50% of the European credit universe (sovereigns, Quasi-sovereign, corporates and financials) still delivered negative yields, this percentage fell, at the end of the year, to less than 25%.

While the rise in bond yields since Trump’s election is not surprising, it nevertheless raises a crucial question: are we witnessing a radical reversal of the underlying trend that has been pushing bond yields down for decades, have we ended with abnormally low rates, or is it “simply” one of those many corrections that we regularly see? Clearly, is it a regime shift, a change of level, or a correction within a fluctuation band?

Nevertheless, the impact of rising US bond yields on European ones should not be overlooked either. The increase in yields can come from 8 main sources:

  1. A significant recovery in growth prospects (actual and / or potential),
  2. Less accommodative interest rate policies,
  3. The end of QEs,
  4. A recovery in inflation,
  5. A significant reversal of fiscal and tax policies,
  6. Questions about solvency (doubts about public debt, rising risk premium ...),
  7. A reversal of the positioning of the portfolios (signalling the end of the low rates environment),
  8. As regards European yields, higher yields on US bonds and a high correlation with the US.

 

Where do we stand now? In the case of the United States, factors 1, 2, 4, 5 and 7 are undoubtedly at the origin of the rise in yields. In the case of Europe, the first three do not materialize (yet) and the fourth is not yet a concern. The fifth takes shape, but not in Europe, in the United States only ... and it will have an impact on the first four. The current debate on tax and fiscal policies is crucial for interest rates and bond yields. The sixth (especially political situation) and the seventh must be closely monitored. Only the eighth is currently highly credible, and with the factors mentioned above, it pushes yields up.

Referring to the table above, five conclusions have to be pointed out:

  1. In the absence of a new growth cycle, US bond yields should remain within a 1.5% to 3% fluctuation band;
  2. There should be no regime shift for the core euro bond yields, as well as for Japanese rates. The level of growth and inflation, as well as the monetary policies carried out, do not justify it.
  3. Contagion from US rates will be limited as long as expectations of regime shift will remain low in the United States.
  4. Only the interruption of QEs seems likely to significantly and permanently change the level of euro area bond yields.
  5. Finally, the European elections and the uncertainty they represent seem, on the other hand, to be sufficiently crucial to bring about a change in the level of peripheral countries bonds’ spreads.

Conclusion

Let us recall three things:

  • In 2016, European bond markets are gradually becoming more dysfunctional, with extremely low levels, in any case far from their usual fundamental values, which is perhaps the biggest risk. As a result of the QE programmes, in particular, the bond market provides unreliable measures (price, yields and volatility), like a barometer that would provide inaccurate measures, and risks (rise vs. fall) became totally asymmetrical.
  • Although European bond markets are dependent on US yields, they are also at the mercy of the ECB’s EQ policy. The end of QE programmes would result in an increase in Bund yields of around 150bp (the current gap between current and equilibrium levels) and a rise in peripheral spreads (to Germany) from 250 to 350bp. In some countries, bond yields would more than double! A real financial crisis… or a bond market crash!
  • The renewed interest in inflation-linked bonds is confirmed. The current configuration has been advocating for this asset class for the past few months. This is a long-neglected asset class, which was heavily underweight in international portfolios, and therefore attractively valued. Added to this is the rise in commodity prices, led by oil, which has a particularly pronounced impact on short duration linkers. Inflation-indexed bonds are not only a good tool for protecting against the rise in price indices, but also an attractive asset in terms of valuation.

 

2017.02---month's-topic--1-partie-2
2017.02---month's-topic--1

 

SUMMARY TABLES

 

2017.02---month's-topic--2

 

The table above represents an investment horizon of six to 12 months. The changes reflect the outlooks expressed at our most recent investment committee meeting. The different lines provide relative outlooks for each major asset class and absolute outlooks for forex and commodities. The outlooks, changes in outlooks and opinions on the asset classes reflect the expected direction (+/-) and the strength of the convictions (+/++/+++). They are independent of the constraints and considerations concerning the construction of portfolios.

 

2017.02---month's-topic--3

 

The table above represents a short investment horizon of one to three months. The changes (column 2) reflect the outlooks expressed at our most recent investment committee meeting. The lines express our aversion to risk and our macro-hedging strategies. They should be viewed in relation to the asset allocation tables. A negative outlook in terms of asset allocation will not lead to hedging. A temporarily negative outlook (negative in the short term but positive in the medium term) may lead us to protect the portfolio, without affecting our long-term outlooks. The application of the strategy is expressed by a position (+), and the scale of the position is expressed by a graded scale (+/++/+++). These strategies are independent of the constraints and considerations concerning the construction of the initial portfolio subject to protection. These are overlay positions.

 

 

 

 

The rise in bond yields since the election of Trump is not surprising… but is it sustainable?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The impact of rising US interest rates on European long rates should not be overlooked

 

 

 

 

 

 

Philippe ITHURBIDE, Global Head of Research, Strategy and Analysis at Amundi
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Long-term rates: a regime shift, a fluctuation band shift?
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